Chapter 16 Notes: Debt Policy and MM Propositions

Chapter 16: Does Debt Policy Matter?

16.1 The Irrelevance of Debt Policy

• Even if new borrowing increases the risk of old bonds, potentially harming old bondholders, this issue is addressed in Chapter 17.
• In this chapter, it's assumed that new debt issuance doesn't affect the market value of existing debt.

16.2 Modigliani and Miller's Proposition 1

• MM's Proposition 1: In a perfect market, a firm's value is unaffected by its capital structure. Any financing package is as good as another.
• Rationale: Issuing fairly priced securities has zero NPV, so substituting one zero-NPV security for another doesn't add value.
• Consider two firms:
  • Firm U: Unlevered, with equity value EU equal to the firm value VU. (EU = VU)
  • Firm L: Levered, with equity value EL equal to the firm value less the debt. (EL = VL - DL)
• Two investment strategies with the same payoff should have the same price (Law of One Price).
  • Strategy 1: Buy 1% of firm U's shares. Investment = 0.01V_U, Return = 1% of profits.
  • Strategy 2: Buy 1% of firm L's debt and equity. Investment = 0.01DL + 0.01EL = 0.01V_L, Return = 1% of profits.
• Since both strategies offer the same payoff (1% of profits), 0.01VU = 0.01VL. Therefore, VU = VL.
• Alternative Strategy:
  • Buy 1% of the levered firm's shares. Investment = 0.01EL = 0.01(VL - D_L), Return = 1% of (Profit - Interest).
  • Borrow 0.01DL and purchase 1% of the unlevered firm's stock. Investment = 0.01(VU - D_L), Return = 1% of (Profits - Interest).
• Again, VU = VL.
• Investors can